Corporate Finance: Structure, Governance, and Valuation

Posted on Dec 16, 2024 in Economy

Market-Based Versus Bank-Based Financial Systems

The financial system of the US and UK is market-based: the stock market and bond market are important for corporate finance. UK’s bank assets include bank loans for European corporations. The financial system of many other countries is bank-based. The financial system of Hong Kong is a hybrid.

US, UK, and Hong Kong Boards of Directors

Directors (agents) are elected by shareholders (principals).
The Board of Directors (BoD) consists of executive directors and non-executive directors (part-time, advisory roles).
They meet periodically (such as monthly).
They make decisions on strategies and big plans (such as Mergers and Acquisitions).
They hire, monitor, and fire top managers.
Top managers (agents) operate the corporation daily and propose big plans.

European Boards of Directors

Germany: Codetermination

Management Board (Vorstand), which operates the corporation.
Supervisory Board (Aufsichtsrat): oversees strategy and elects and monitors the management board.
- For corporations with more than 2000 employees, half are elected by employees, and half are elected by shareholders.
- For smaller corporations, one-third are elected by employees, and two-thirds are elected by shareholders.
- Some directors may be executives of banks lending to the corporation.

France

France has a one-tiered board (similar to the US) or two-tiered boards (similar to Germany).

Stakeholder Capitalism

Stakeholder capitalism is a form of capitalism in which managers act in the interest of all stakeholders.

Main Criticisms of Stakeholder Capitalism

No clear rule to replace Net Present Value (NPV).
- For example, how to assess the trade-offs between stakeholders?
The Council of Institutional Investors (in the US) argues that “accountability to everyone means accountability to no one.”

Friedman’s Argument and Enlightened Shareholder Value

Friedman based his argument on three assumptions:

Government policy ensures companies will engage in socially responsible behavior.
Maximizing shareholder value gives shareholders maximum freedom to support the social objectives they care about.
Maximizing shareholder value requires companies to invest in stakeholders.

This is related to a more recent idea: Enlightened Shareholder Value.

Enlightened Shareholder Value

Investing in stakeholders usually creates shareholder value.
Companies invest in stakeholders only if doing so is +NPV.
- Stakeholders are a means to an end.
Two practical advantages:
- Clear criterion for making investment decisions.
- Clear criterion for judging performance.

Stockholder Primacy

Our course assumes stockholder primacy for three reasons:

Stockholder primacy is still the case in the US and Hong Kong (as well as the UK).
It leads to a clear framework for making decisions, e.g., we calculate NPV to accept or reject new projects.
It takes into account most effects on stakeholders.

Pyramid and Dual-Class Shares

Dual-class shares have different voting rights, the same cash-flow rights, and a similar price per share.
- An example in the US: Facebook.A and Facebook.B.
- An example in Hong Kong: Swire.A and Swire.B.
- A rare exception: BRK.A and BRK.B have different prices per share, and fair cash-flow and voting rights.
Having 33% votes or more in each layer of the pyramid, Wallenberg’s effective control of ABB is almost 100%, unless there is successful collusion by the other shareholders to oppose the major shareholder.
Wallenberg’s investment = $(0.243 x 0.271 x 0.234) for each dollar of market capitalization of ABB.
Wallenberg’s cash-flow rights = $(0.243 x 0.271 x 0.234) for each dollar of cash dividend from ABB.
Consequently, Wallenberg’s effective voting rights are greater than what they deserve (according to their investment in ABB).

Agency Problems: US vs. Hong Kong

A typical US corporation (widely-held): conflicts between the directors/managers and all the stockholders.
Hong Kong: conflicts between the controlling stockholder (who is a principal as well as the manager or the agent for other principals) and other stockholders.
Agency problems may be more severe in Hong Kong than in the US.
- There are differences in corporate governance (the laws, regulations, institutions, and corporate practices that protect shareholders and other investors).
- While Hong Kong big-cap companies may have reasonable corporate governance, some Hong Kong mid-cap or small-cap companies may not.

Legal and Regulatory Requirements

The Securities and Futures Commission (SFC) in Hong Kong (Securities and Exchange Commission (SEC) in the US) and the stock exchange set accounting and reporting standards as well as laws protecting minority shareholders from exploitation.
- E.g., semi-annual versus quarterly financial reporting; less detailed, less reliable versus more detailed, more reliable financial statements.
- The US allows class action, whereas Hong Kong doesn’t.

Board of Directors

US

Sarbanes-Oxley Act (“SOX”): more than half of the directors must be independent of the managers. In an average board, 85% are independent non-executive directors.
Blockholders (each holding >5% of shares) such as institutional shareholders usually nominate directors.

Hong Kong

Only one-third of directors must be independent of the managers.

NPV Rule and Financing Costs

There is no need to include financing costs in the NPV rule. Financing costs and the tax shields from interest are automatically considered when we discount the project cash flows using the suitable discount rate. Thus, NPV should ignore financial cash flows and consider operating cash flows.

Calculating Operating Cash Flow

We usually start with forecasted accounting numbers, such as sales, taxes, and depreciation, and then make suitable adjustments to arrive at operating cash flow:

We first regard depreciation (calculated according to tax law) as an expense to calculate tax (an important cash flow).
Then we add back depreciation (a non-cash expense) to arrive at operating cash flow.

Sales (Operating Revenue) – Operating Costs Including Depreciation (calculated according to tax law, but we assume straight-line; see the textbook for US tax law if you are curious) = Pre-tax Profit or EBIT
EBIT x Tax Rate (note: interest expense is ignored) = Tax On Operations
EBIT – Tax On Operations + Depreciation = Operating Cash Flow

Net Cash Flow Calculation

Operating Cash Flow in a year – Net Capital Spending (= after-tax asset purchase, if any in a year, minus after-tax asset disposal, if any) – Change in Net Working Capital during a year = Net Cash Flow in the year

Fixed Asset Purchase and Disposal

Fixed asset purchase is a cash outflow (nonzero in initial years).
After-tax cash flow from disposal of the asset at the project end:

= [expected salvage value of the used asset] – [tax rate x (expected salvage value – book value)]
Book value = initial cost – accumulated depreciation (based on tax law, see the textbook)
If expected salvage value < book value, then expected tax refund.

Adjusting for Net Working Capital

Some sales and operating costs are accrued, e.g., sales on credit: increase in accounts receivable, included in revenues, but no cash flow yet.
Similarly, need to adjust for other items such as change in accounts payable.
Thus, need to adjust for change in net working capital (current assets excluding cash ‒ current liabilities excluding short-term bank loans).

Changes in Net Working Capital

When a project begins:
- Inventories build up, increase in receivables.
- Partially offset by an increase in payables.
- Net working capital increases from zero.
When a project ends:
- Inventories are sold, and receivables are collected.
- Partially offset by a decrease in payables.
- Net working capital decreases to zero.
There may also be year-to-year changes in net working capital.
- Deduct the change in net working capital (NWC_{year end} – NWC_{year begin}).

NPV Formula

NPV = value of a new project – initial cost or cash outflow

The value of a project = PV of expected NCF in the future.
NCF in year t = [Operating Cash Flow (OCF) – net capital spending (NCS) – changes in Net Working Capital (NWC)] in year t.
- OCF = EBIT + depreciation – taxes (calculated as if no interest expenses).
- NCS = After-tax asset purchase – After-tax asset disposal.

Total Cash Flow

Total cash flow CF CF CF= + + Capital Investment Operations Changes in Working Capital.
Total cash flow is equivalent to NCF.

Cash flows from capital investment are negative (i.e., cash outflows) = -1 x NCS.
Cash flows from changes in working capital are negative (i.e., cash outflows) = -1 x change in NWC.
Thus, the above equation is the same as the previous slide, which is shown in some other textbooks (that you may have seen in FINA 2010).

Relevant Cash Flows for a New Project

A relevant cash flow for a new project is a change in the firm’s overall future cash flow that comes about as a direct consequence of the project.

Ignore any cash flow that exists regardless of whether the project is undertaken.
- E.g., sunk costs.
- E.g., overhead costs, if any, allocated by accountants to the new project.
Consider opportunity costs: the most valuable alternative that is given up if the new project is undertaken.
Consider side effects (or incidental effects) on existing projects.

Discount Rate (r)

The new project may be financed by new debt and new equity.
- The cost of debt: the required or expected return of debt, E(r_debt), per annum.
- The cost of equity: the required or expected return of equity, E(r_equity), per annum.
Use (1-T_C)E(r_debt) & E(r_equity) to calculate after-tax WACC, where T_C is the corporate tax rate.
r = after-tax WACC (or, simply, WACC).

Suitable Discount Rate

New debt: E(r_debt) is usually observable.
- New bank loans?
- New bonds?
New equity: E(r_equity) is to be estimated using ?.
- Cost of new increase in retained earnings: the focus of this set of notes.
- Later notes will talk about issuing new shares and the additional costs.